EXHIBIT 16.4 Short ratio spread at expiration.
This strategy is a mirror image of the backspread discussed previously in
this chapter. With limited risk to the downside, the maximum loss to the
trade is the initial debit of 1 if the stock is below $70 at expiration and all
the calls expire. There is a maximum profit potential of 4 if the stock is at
the short strike at expiration. There is unlimited loss potential, since a short
net delta is created on the upside, as one short 75 call is covered by the long
70 call, and one is naked. The breakevens are at $71 and $79.
Low Volatility
With the stock at $71, gamma and vega are both negative. Just as the
backspread was a long volatility play at this underlying price, this ratio
vertical is a short-vol play here. As in trading a short straddle, the name of
the game is low volatility—meaning both implied and realized.
This strategy may require some gamma hedging. But as with other short
volatility delta-neutral trades, the fewer the negative scalps, the greater the
potential profit. Delta covering should be implemented in situations where
it looks as if the stock will trend deep into negative-gamma territory.
Murphy’s Law of trading dictates that delta covering will likely be wrong at
least as often as it is right.